Dominion Power 2001 Annual Report Download - page 67

Dominion designates a substantial portion of derivatives
held for purposes other than trading as fair value or cash flow
hedges. A significant portion of Dominion’s hedge strategies rep-
resents cash flow hedges of the variable price risk associated with
the purchase and sale of electricity, natural gas, oil and other
commodities. Dominion also uses cash flow hedge strategies to
hedge the variability in foreign exchange rates and variable inter-
est rates on long-term debt. In its cash flow hedges, Dominion
uses the derivative instruments discussed in the preceding para-
graphs. Dominion also engages in fair value hedges by using nat-
ural gas swaps, futures and options to mitigate the fixed price
exposure inherent in its firm commodity commitments. In addi-
tion, Dominion has designated interest rate swaps as fair value
hedges to manage its exposure to fixed interest rates on certain
long-term debt. Certain non-trading derivative instruments are
not designated as hedges for accounting purposes. However,
management believes these instruments represent economic
hedges that mitigate exposure to fluctuations in commodity
prices and interest rates.
Accounting Policy
Under SFAS No. 133, derivatives are recognized on the consoli-
dated balance sheets at fair value, unless an exception is available
under the standard. Commodity contracts representing unreal-
ized gain positions are reported as derivative and energy trading
assets; commodity contracts representing unrealized losses
are reported as derivative and energy trading liabilities. In addi-
tion, purchased options and options sold are reported as deriva-
tive and energy trading assets and derivative and energy trading
liabilities, respectively, at estimated market value until exercise
or expiration.
For all derivatives designated as hedges, Dominion formally
documents the relationship between the hedging instrument
and the hedged item, as well as the risk management objective
and strategy for using the hedging instrument. Dominion
assesses whether the hedge relationship between the derivative
and the hedged item is highly effective in offsetting changes in
fair value or cash flows both at the inception of the hedge and on
an ongoing basis. Any change in fair value of the derivative that
is not effective in offsetting changes in the fair value of the
hedged item is recognized currently in earnings. Further, for
derivatives that have ceased to be highly effective hedges,
Dominion discontinues hedge accounting prospectively.
For fair value hedge transactions in which Dominion is
hedging changes in the fair value of an asset, liability, or firm
commitment, changes in the fair value of the derivative will
generally be offset in the consolidated statements of income
by changes in the hedged item’s fair value. For cash flow
hedge transactions in which Dominion is hedging the
variability of cash flows related to a variable-priced asset, liability,
commitment, or forecasted transaction, changes in the fair
value of the derivative are reported in AOCI. Derivative gains
and losses reported in AOCI are reclassified as earnings in the
periods in which earnings are impacted by the variability of the
cash flows of the hedged item. The ineffective portion of the
change in fair value of derivatives and the change in fair value
of derivatives not designated as hedges for accounting purposes
are recognized in current period earnings. For foreign currency
forward contracts designated as cash flow hedges, hedge effec-
tiveness is measured based on changes in the fair value of the
contract attributable to changes in the forward exchange rate.
For options designated either as fair value or cash flow hedges,
changes in time value are excluded from the measurement of
hedge effectiveness and are therefore recorded in earnings.
Gains and losses on derivatives designated as hedges,
when recognized, are included in operating revenue, expenses
or interest and related charges in the consolidated statements of
income. Specific line item classification is determined based
on the nature of the risk underlying individual hedge strategies.
Changes in the fair value of derivatives not designated as
hedges and the portion of hedging derivatives excluded from
the measurement of effectiveness are included in other operation
and maintenance expense in the consolidated statements of
income. Cash flows resulting from the settlement of derivatives
used as hedging instruments are included in net cash flows from
operating activities.
2001 Derivatives and Hedge Accounting Results
Dominion recognized a pre-tax net gain of $2 million for hedge
ineffectiveness during 2001. This amount includes a pre-tax
gain of $3 million related to cash flow hedges and a loss of $1 mil-
lion related to fair value hedges. In addition, Dominion recog-
nized a net pre-tax loss of $45 million during 2001, representing
the change in time value excluded from the measurement of effec-
tiveness for options designated as cash flow hedges subsequent to
January 1, 2001.
Approximately $209 million of net gains in AOCI at
December 31, 2001 is expected to be reclassified to earnings
during 2002. The actual amounts that will be reclassified to
earnings in 2002 will vary from this amount as a result of
changes in market prices. The effect of amounts being reclassi-
fied from AOCI to earnings will generally be offset by the recog-
nition of the hedged transactions (e.g., anticipated sales) in
earnings, thereby achieving the realization of prices contem-
plated by the underlying risk management strategies. As of
December 31, 2001, Dominion is hedging its exposure to the
variability in future cash flows for forecasted transactions over
periods of one to seven years.
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